Outsourcing to China doesn’t pay off

May 1, 2014 - 06:06

Danish companies are barking up the wrong tree when they shift their production to China. There is actually more profit in sending part of the production to expensive countries such as Germany, new study suggests.

It is far cheaper for European companies to have some products manufactured in Asia, but from a business point of view, it makes much more sense to turn away from Asia and instead dream of the big gains that can had in Europe, new study suggests. (Photo: Shutterstock)

Danish researchers have some news that might cause a few companies to think twice about outsourcing. Contrary to popular belief, it may not be worthwhile to outsource parts of production to low-salary countries such as China and India.

There is far more profit in outsourcing part of the production to countries near Denmark with much higher salaries, such as Germany, Sweden and the UK.

Positive effect only when outsourcing to rich countries

So concludes a new, as yet unpublished, study from Aarhus University, Denmark. The study is based on figures from all large Danish companies that outsourced part of their production activities in the period 1995-2006.

”My study shows that companies generally benefit from outsourcing. But if you look at which countries these services are being outsourced to, you see that the companies do not have a positive effect if they outsource to non-OECD low- and medium-income countries. Companies should outsource to high-income countries; that’s where they’ll find the positive effect,” says Roger Bandick, an associate professor at the Department of Economics and Business at Aarhus University.

High-salary countries boost productivity and development

My study shows that companies generally benefit from outsourcing. But if you look at which countries these services are being outsourced to, you see that the companies do not have a positive effect if they outsource to non-OECD low- and medium-income countries. Companies should outsource to high-income countries; that’s where they’ll find the positive effect.

Roger Bandick

Bandick’s analysis of data from Statistics Denmark shows that while all companies benefit from outsourcing compared to those that do not outsource, the companies that outsource to high-salary countries benefit more than those that outsource to low- and medium-salary countries. The former gain an extra:

Two percent on productivity.

Fifteen percent on product development.

Twenty percent on export intensity – i.e. the proportion of sales that comes from exports.

Three good reasons to outsource to rich countries

Bandick has three possible explanations to why Danish companies benefit from investing in Europe rather than e.g. in Asia.

We’ll start with an imaginary example: a Danish producer of hearing aids needs various parts to build a new hearing aid, for instance a speaker and a microphone, which the company decides to have manufactured overseas.

From a business point of view, the company would be better off having the parts produced in Germany than in the cheaper China, because:

The quality is higher. Germans are good at making speakers – and maybe the Poles are good at making microphones. By exploiting the strengths we know each country has, the end product – the hearing aid – will be of the highest quality.

The closer to Denmark the parts are being manufactured, the lower the cost of importing them to Denmark.

Countries far away from Denmark are likely to have a different culture, other rules and perhaps other forms of communication, which may make it harder or more expensive to manufacture e.g. speakers and microphones that fit perfectly into the end product.

We shouldn’t just outsource indiscriminately. It is important that companies think about what production they have and whether it’s necessary to outsource, or whether to keep all production inside the Danish borders.

Roger Bandick

So even though costs are lower in China, there are costs that may end up eroding the gains that the company expected to see.

”This shows that we shouldn’t just outsource indiscriminately. It is important that companies think about what production they have and whether it’s necessary to outsource, or whether to keep all production inside the Danish borders,” says Bandick.

“They should also consider whether to focus on quality rather than trying to save on production costs when they outsource.”